Thursday, 16 April 2015

Monetary Policy – where has the magic gone?

The
European Central Bank tries to cast another spell to save the Eurozone but its
magic has been stolen

Monetary policy is like magic – you have to
use tricks to get people into believing what you want them to believe. Both magicians and central banks apply
various devices to convince their audience that they can pull off amazing
feats. A bit of showmanship can be
crucial in creating an aura of the fantastical when your powers are actually
rather limited. Central banks have
pulled this off in the past but quantitative easing by the European Central
Bank is more likely to show that it does not have any rabbits left to pull out
of the hat.

Trying
to work magic

Your Neighbourhood Economist likes to look
back fondly to an era when central banks had the financial market enthralled
with their mastery of all things economic.
This admiration was won the hard way in the 1980s by bringing
double-digit inflation back to more manageable levels and ushering in an era
where the booms and busts seemed to have past.
But central banks have been taken down a notch by their inability to revive the economy
after the global financial crisis.

With few other options seen as viable,
quantitative easing has gone from an unconventional measure to the mainstay
policy for central banks despite questions over its usefulness. The European Central Bank has been slow to
try its hand at quantitative easing even though the Eurozone economy was
struggling more than most. This was
because Germany (who had initially done well despite its neighbours being in
crisis) was firmly against the central bank in Europe printing cash to buy
government bonds. It was only after a further considerable deterioration in the prospects for the Eurozone (as well as that of Germany itself)
that the European Central Bank to override this opposition.

No
more magic left

The European Central Bank has been put at a
disadvantage considering that the other big central banks have already tried to
work their magic through quantitative easing.
Investors are becoming harder to impress having already seen central
banks pull off similar tricks. To
maintain the wow factor, quantitative easing has needed to get bigger and
bigger. The central bank in Japan
pledged to double the money supply within two years but had to offer up even more cash when
its initial plans proved to be lacking.

The European Central Bank cannot compete on
scale as it has to perform magic with one hand behind its back due to the
political constraints within the Eurozone.
Any extra boost using the element of surprise was also dented by the
protracted process as the European Central Bank and Germany squabbled publicly
over quantitative easing in the months before the policy was launched.

The fractious politics in Europe has sapped
power from the central bank who had previously been the main shining light in
saving the Eurozone. Political squabbles
have highlighted the limited power at the disposal of the European Central
Bank. It is like a magician who is being
sabotaged by their own assistant – it will take more than magic to escape this
spell.